In 2018 non-compliance with Environmental and Sustainable Governance (ESG) requirements will become operational crises which in turn will become governance crises and boards need to be ready to answer some critical questions from investors. If companies want a fair hearing in the press, they need to start communicating their good governance and ESG credentials as part of their triple bottom line.
In many ways, this new reality has been a long time to come, and many factors are driving the change. In 2017, we have witnessed money is shifting from active to passive (passive shareholders but active owners). Twenty years ago, passive funds owned 5% of the market. Today they own about 25%. At the current rate of transition, they will hold 50% by 2028. This forecast is changing market dynamics but also forcing boards to evaluate their ESG narratives and positioning around key issues.
The CEO of Vanguard has said "We are going to hold your stock when you hit your quarterly earnings target. Moreover, we will hold it when you do not. We are going to hold your stock if we like you, Moreover, if we do not. We are going to hold your stock when everyone else is piling in and when everyone else is running for the exits. That is precisely, why we care so much about good governance", which does not give many companies the option but to act.
While the year 2017 has witnessed an increase in capital flows into passive funds such as Vanguard it has also seen a rise in shareholder activism focused on how companies manage their Environmental and Sustainable Governance (ESG). What will happen is in a tightening of the requirements as to what the public and investors consider acceptable operating behaviour. In 2018 it will be hard for businesses without a strong narrative to get off the hook and avoid awkward questions about their sustainability policies.
Why? Because the world is changing and there have been some critical ESG related events, and trends in 2017 which when taken together are the start of long-term patterns for which the industry must start to take seriously.
The first was the announcement by Norway’s $1 trillion Sovereign Wealth Fund its intention to sell its holdings in the supermajor crude producers in its portfolio caught the attention of the market. Earlier in the year both BNP Paribas and HSBC announced, they would be reducing funding of projects in oil, gas and coal. BNP Paribas will stop doing business with companies whose primary activity involves oil and gas extracted from shale deposits or tar sands in one of the most aggressive steps so far by an international bank to reduce exposure to fossil fuels. These moves alone remove a significant amount of capital from the oil and gas sector.
Another factor is in understanding the support for the Paris Agreement. On one level it is President Macron, Bill Gates, Michael Bloomberg and global governments. On the other, it is the people who have been socialised in climate science over the last twenty years who are now the investors and analysts calling for changes. For this generation climate change is not seen as a distant threat, it is real, and it is something to be tackled.
Being present in the reality of this moment cutting through the Trump rhetoric and understanding the real public sentiment is an essential task for global boards to undertake. A comprehensive PEW Research report has indicated that 51% of people say climate change is already harming people around the world, while another 28% believe it will do so in the next few years.
This view is especially prevalent in Latin America. For instance, fully 90% of Brazilians say climate change is harming people now. Europeans are also particularly likely to hold this opinion. These are all customers of shareholders, and the figures indicate that a company with a worldwide portfolio will need to be aware of these changing views to ESG and climate and have a narrative developed for each region.
However, only 41% of Americans believe people will be hurt by climate change today, which makes sense given the historical reluctance to engage with climate science and the political conflation of global warming with 'big government'.
One of the significant aspects of the ESG side of the insurance market which leads to this tendency to proliferation is the inherently subjective nature of the information on which investment selection can be made. By definition ESG data is qualitative; it is non-financial and not readily quantifiable in monetary terms. The investment market has long dealt with these intangibles – such variables as ‘goodwill’ have been widely accepted as contributing to a company’s value. However, the ESG intangibles are not only highly subjective they are also particularly difficult to quantify and more importantly verify.
In 2018 non-compliance with ESG requirements will become operational crises which in turn will become governance crises and boards need to be ready to answer some critical questions from investors.
• What are the management processes in place to foresee and manage the problem of the changing landscape and the ESG demands from stakeholders?
• What is the board oversight in complete company ESG reporting?
• If the management team do not have risk processes in place and the board do not have oversight processes in place, then shareholders will likely be an argument about governance which will compound pressure from the operational crisis.
The reality and I have argued this for a long time, is that ESG narrative is becoming the core part of a company’s ‘license to operate’ narrative. The license to operate narrative appeals to the heart and is part of a company’s ‘North Star’ narrative which encompasses their financial and strategic narrative.
Without a license to operate narrative, companies will find it harder to attract and retain talented employees, will turn off millennial customers, will find themselves more likely to be regulated by governments, and will get less of a fair hearing in the press.